Types of Retirement Plans

Certain types of retirement plans, called qualified retirement plans, are specified in the tax code, giving plans that conform to the requirements tax advantages over other nonqualified plans.

Qualified retirement plans have common characteristics but they differ primarily in the amount that can be contributed each year. Obviously, higher contributions allow a greater retirement benefit. The deadline for annual contributions is the date of filing the tax return for that year, including extensions.

Employer-provided retirement plans generally have a vesting requirement. Vesting is the right that the employee has in the contributions provided by the employer. Generally, employers require a minimum employment period before the employee is entitled to retirement contributions by the employer. Employees are always vested in their own contributions but the employer can establish a vesting schedule for matching contributions. So if an employee is only 30% vested, then leaves the job, then he could take all his own contributions + 30% of the employer contributions.

The Secure Act 2.0, passed at the end of 2022, makes it easier for employers to help workers open emergency savings accounts, assist employees who are repaying student loan debt and allow part-time workers access to retirement plans in 2 years instead of 3. There are also new benefits to both Roth IRAs and Roth 401(k)s, including moving leftover money from a 529 college savings account to a Roth I.R.A. Certain rules must be followed to avoid taxes and penalties, and there are some income restrictions. However, some provisions start in different tax years.

Secure Act 2.0 changes for IRAs:

Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 (SECURE Act) has changed the law regarding qualified tax-deferred retirement accounts:

With employer-provided plans, the employee chooses investment options selected by the employer, such as stock funds, bond funds, money market funds, or even company stock.

Most of the plans are defined contribution plans, where the plan benefit is determined by the amount of the contributions over the lifetime of the plan. There are also defined benefit plans where the retirement benefit is a specified amount that is received annually. Contributions are determined by mortality tables and by the amount of the annual defined-benefit that the retiree wishes to receive. However, this type of plan allows the maximum tax-deductible contribution of up to $200,000 for 2012. The contribution limits are adjusted for inflation and can be found at COLA Increases for Dollar Limitations on Benefits and Contributions.

There are 3 IRA-based plans that are easy to set up and maintain, and have no annual filing requirements: the traditional and Roth IRA, Simplified Employee Pension (SEP), otherwise known as the SEP-IRA, and the SIMPLE IRA. Any employer can set up IRAs and SEPs, but only an employer with 100 or fewer employees who does not provide another type of retirement plan can set up a SIMPLE IRA. To set up a SEP, the IRS provides Form 5305-SEP. Form 5304-SIMPLE and 5305-SIMPLE can be used to set up a SIMPLE IRA. There is a tax credit for small employers of up to $500 per year for the 1st 3 years for setting up a SEP, SIMPLE, and certain other retirement plans.

The following types of plans are classified by the IRS as defined contribution plans:

Although IRA-based plans are also defined contribution plans, the 401(k) plans and the profit-sharing plan all require the annual filing of Form 5500, Annual Return/Report of Employee Benefit Plan and all can be established by any employer.

For 401(k) plans, an employee can contribute $19,000 for 2019 and 50+ year-old employees can contribute an additional $6000 as a catch-up contribution. Employers can also contribute to the plan for the employees, but the combined contribution from both employer and employee cannot exceed 100% compensation or $56,000 for 2019. If the employee chooses and the plan allows it, the employee can contribute to a Roth 401(k) with after-tax income, which is taxed like a Roth IRA — contributions are not tax-deductible, but withdrawals are tax-free. Since 2013, employees may make an in-plan conversion from a regular 401(k) to a Roth 401(k), if the employer's plan allows it. Although such conversions were allowable before, they could only be done under certain situations, such as when the employee reached 59½.

The employer can deduct contributions of up to 25% of the aggregate compensation for all participants + all salary reduction contributions. However, the employer must satisfy an annual test to show that excess contributions or deferrals have not been made for highly compensated employees; otherwise, the excess will be subject to a 10% excise tax. Safe harbor 401(k) plans also require that the employer make a specified matching contribution of 3% to all participants, but this type of plan does not require the annual test that applies to the other 401(k) plans.

Contributions to profit-sharing plans are made entirely by the employer and the amount deductible is the lesser of 100% of employee compensation or $56,000 for 2019. However, the employer cannot deduct any more than 25% of the aggregate compensation for all plan participants.

A defined-benefit plan can also be set up by any employer and also requires the annual filing of Form 5500. Although this type of plan offers the greatest contribution deduction, it requires an actuary to determine annual contributions; other professional help will also be necessary in settling up this type of plan. The employer is required to contribute a specified amount to the plan annually and is generally the most expensive type of plan to maintain. Because of its expense, few employers offer this type of plan.

All 401(k) plans, profit-sharing plans, and defined-benefit plans have a nondiscrimination requirement in that the plans must be offered to all employees who are at least 21 years old and who worked a minimum of 1000 hours in the previous year, and 401(k) plans, except for the safe harbor 401(k) plan, also require annual nondiscrimination testing to ensure that the plans do not favor highly compensated employees.

Employee contributions vest immediately, meaning that the employee has an irrevocable right to the amount contributed, but contributions by the employer usually vest over time according to the terms of the plan, generally requiring the employee to work a specified number of years for the employer before the employer's contribution vests. However, employer contributions to a safe harbor 401(k) or a SIMPLE IRA plan vest immediately.

Individual Retirement Accounts (IRAs)

Unlike retirement accounts offered by employers, IRAs are set up by individuals. IRAs have a contribution limit of the lower of earned income or $6,000 + $1,000 for individuals 50 or older. The funds in IRAs can be invested in stocks, bonds, mutual funds, and other investments. The taxpayer can have both an IRA and another retirement plan. For married taxpayers where 1 spouse does not work, a contribution can be made by the working spouse to the nonworking spouse's separate IRA, allowing the working spouse to deduct both contributions.

The contributions to a traditional IRA are deductible as an adjustment for gross income. The taxpayer is required to receive distributions after age 72. Ordinary income taxes must then be paid on the distributions. Tax savings result from the tax-free growth of earnings and the fact that most people will be in a lower tax bracket when they retire. Additionally, no employment taxes are deducted from the withdrawals, since employment taxes were already assessed on the contributions.

However, there are income phaseout rules that apply to the traditional IRA if the taxpayer is an active plan participant in an employer's retirement plan. If the taxpayer already has a qualified retirement plan at work, he can still have an IRA, but only if his income is less than the upper phaseout amount. If the taxpayer is over the income limit, then he could still make a contribution to an IRA and it can still grow tax-free, but contributions are not tax-deductible.

A Roth IRA allows the taxpayer to make contributions from after-tax earned income. However, not only does the money grow tax-free, but it can be withdrawn tax-free as well. Furthermore, there are no required distributions from a Roth IRA since the government does not receive any tax revenue from the distributions. There are no age limits on contributions, so a Roth IRA can be established by an 80-year-old. However, contributions to a Roth IRA, like those to a traditional IRA, must come from working income.

The phaseout rules for a Roth IRA are higher than for a traditional IRA, but the rules apply even if the taxpayer is not an active plan participant. Withdrawals of the contributions can be made without penalty at any time. However, earnings cannot be withdrawn before age 59½ and the account must have been held for at least 5 years; otherwise, a 10% tax penalty will apply to the distribution unless an exception applies.

For each IRA account, the taxpayer must sign a beneficiary designation form, which specifies the beneficiaries of that account. Beneficiaries should always be designated, because if they are not, then the IRA assets will be transferred to the decedent's estate, in which case, they will be subject to probate.

Tax Tips — Who to Name as Beneficiaries of an IRA Account

Some taxpayers must decide whether to designate a surviving spouse, children, or a living trust as a beneficiary of an IRA account. Beneficiaries can either receive the income over the allotted time or receive it as a one lump distribution. Receiving it over time defers taxes the most, often called a stretchout. Generally, there are more tax deferral options if a surviving spouse is named as a beneficiary rather than a living trust, since the surviving spouse can roll over the IRA assets into her own IRA account, thereby stretching out the deferral period. The children can be named as contingent beneficiaries. Each child beneficiary could take a distribution based on their own life expectancy, but if a trust is a contingent beneficiary, then the distributions to each child must be based on the life expectancy of the oldest child.

Tax Tip — Tax-Free Distributions to Charitable Organizations

IRA owners who have reached 70½ are permitted to donate up to $100,000 from their IRAs to charitable organizations, thereby eliminating the tax on the distribution, but which, nonetheless, still counts toward the required minimum distribution.

Payroll Deduction IRA

Some employees have trouble saving for their retirement, so federal law allows an employer to set up a payroll deduction IRA with a financial institution and offer the option to its employees, where the employer will deduct specified amounts from the payroll of employees who have chosen this option. The employees can choose between a traditional IRA or a Roth IRA, and they can terminate the payroll deductions at any time. Any costs or limits on the employee's ability to transfer contributions to another IRA provider must be disclosed before the employee's participation. Employees should be notified that they can contribute to any IRA outside of the payroll deduction program and that there is no benefit to the deduction other than convenience.

The employer can choose the IRA providers and can decide to use only one or more. There are no contributions from the employer and the program will not be treated as an employer retirement plan that requires reporting to the IRS and fiduciary responsibilities, as long as the employer involvement is minimal. An employer cannot seek special terms from the IRA provider or influence either the investments provided or the investments that are made. Additionally, the employer cannot seek any compensation from the IRA provider other than reimbursement for the actual cost of forwarding the payroll deductions. The employer's only involvement is to collect employee contributions, then forwarding them to the IRA provider.

The employer can terminate the payroll deduction IRA program at any time, simply by notifying the employees and the IRA provider; notification to the IRS is unnecessary.

Simplified Employee Pension Plans (SEPs)

SEPs (aka SEP-IRA) follow the same rules as for IRAs, but have a higher annual contribution limit, and can cover both the self-employed and employees. However, contributions must be cash, not property. Employees cannot contribute to the SEP, only the employer does. The contribution limit is the smaller of 25% of employee compensation, 20% of net business income for the employer or self-employed, or the SEP contribution limit. Contributions can also be made for employees older than 72 and the self-employed can also continue making contributions for themselves, but they must start receiving required minimum distributions after reaching 72.

For simplified employee pensions, the employer must pay a set percentage of each employee's wages up to the lesser of 25% of compensation or the SEP contribution limit (adjusted annually for inflation), but the payment does not have to be made every year. However, the contribution percentage cannot be applied to wages exceeding the SEP wage base, since this would favor highly compensated employees.

SEP Contribution Dollar Limits and Maximum Wage Base
2024 $69,000 $345,000
2023 $66,000 $330,000

For employers and the self-employed, net business income is calculated by subtracting all business expenses from business income minus ½ of the self-employment tax and minus the SEP contribution to calculate the 20%. However, only income earned from conducting the business can serve as the basis for a SEP contribution — investment income, such as interest, dividends, or capital gains from property sales — cannot be used to figure the contribution limit.

The contribution rate can vary from 1% to 25% for employees, but the rate for the employer is set by a formula tying the employer's rate to the employees' rate:

Employer's Contribution Rate = Employees' Rate
1 + Employees' Rate

So if the business owner wants to claim the full 20% of net business income, then the contribution rate for employees must also be set to the maximum employee rate of 25%:

Employer's Contribution Rate = .25/1.25 = .20 = 20%

Eligibility rules:

SIMPLE IRAs and SIMPLE 401(k)'s

SIMPLE IRAs (Savings Incentive Match for Employees) allows larger annual contributions and deductions than a traditional IRA. The employer must make an annual contribution for each employee. SIMPLE IRAs, like traditional IRAs, are not taxed until the funds are withdrawn.

A SIMPLE IRA plan can be set up by employers with 100 or fewer employees, where both the employer and the employees contribute to the plan. The 100 employee limitation applies to all businesses under the common control of the employer. The plan can be set up to automatically enroll employees but must allow the employee to opt out of the salary reduction contribution. SIMPLE IRA's are easy to set up since most of the paperwork is done by the financial institution holding the IRA accounts. Employees can decide how the money will be invested.

Employees can contribute up to $13,000, or $16,000, if the employee is 50 or older. The employer can match the contribution up to 3% of the employee's wages. If the employer decides not to match the employee's contribution, then the employer can make a flat contribution of 2% of the employee's compensation or $4600, whichever is lower. The employer's matching contribution may be less, but not more, than the employee's contribution. For the self-employed, contributions are limited to the lesser of net business income or $13,000, or $16,000 if the taxpayer is 50 years or older. However, a business owner can double his own contribution, raising the maximum contribution to ($13,000 + $3,000) × 2 = $32,000.

Employers must contribute to all employees who earned, or are expected to earn, at least $5000 during the tax year, and if they earned at least $5000 in any 2 prior years. No other restrictions may be applied, such as the age of the employee or the number of hours worked. Withdrawal rules and penalties are the same as for traditional IRAs and they can be set up by mutual fund companies, banks, and brokerages. The IRS provides model forms that allow either the employer or the employees to choose their financial institution that will hold their accounts: Form 5304-SIMPLE for the employees and Form 5305-SIMPLE for the employer.

Contribution Limits for SIMPLE 401(k) Plans
Tax Year Maximum Employee Contribution Catch-Up Contribution Employee Contribution + Catch-Up Contribution
2024 $16,000 $3500 $19,500
2023 $15,500 $3500 $19,000

SIMPLE 401(k)'s have most of the same characteristics and requirements as SIMPLE IRAs. However, the employer must file Form 5500 annually. Employees are permitted to take out loans from the account and they can withdraw money. However, early withdrawals may be subject to 10% penalty if the withdrawals are not qualified according to IRS rules, such as being at least 59½.

Profit-Sharing Plans

A business does not have to be profitable to offer a profit-sharing plan, although it does help. Only the employer contributes to the plan, but the contribution is discretionary. If the business is financially stressed, then the employer can skip the contribution until it is in a better financial position. The business must file Form 5500 annually and must also annually satisfy the nondiscrimination test, meaning that the plan does not favor highly compensated employees.

Although the employer contribution is discretionary, the contribution for each employee must be allocated according to a specified formula. The most common type of formula is what is known as the comp-to-comp method, where the contribution for each employee is calculated by dividing the employee's compensation by the total compensation paid to all employees, then multiplying that fraction by the total contribution.

Example: Comp-to-Comp Method for Determining Contributions for Each Employee

If an employer contributes $20,000 to a profit-sharing plan and the employer has 4 employees, 3 of whom earn $40,000 per year and the other earns $80,000 per year, then:

Defined-Benefit Plans

Defined-benefit (DB) plans offer the largest deductible contribution, which, in 2018, can be as much as $2,000 of the plan's unfunded current liability. However, they are the most complex type of plan and the most costly. Form 5500 and Schedule B (Form 5500), Actuarial Information must be filed annually and an enrolled actuary must determine the funding levels of the plan and sign Schedule B. Any employer, including the self-employed, can set up a DB plan, even if they have other retirement plans. The employer makes the largest contribution to these plans, while contributions from employees can either be mandatory or voluntary. Contributions by the self-employed are limited to net self-employment income.

Because of their expense, defined-benefit plans are set up mostly for the self-employed, especially for older people who have not accrued substantial retirement benefits. Generous retirement benefits can be obtained within a short time with this type of plan if the taxpayer is earning a substantial income that would allow large contributions to the plan. However, because of the cost of funding and administering DB plans, few employers offer DB plans to employees, and the number of DB plans, according to the Pension Benefit Guaranty Corporation, has declined substantially since 1985.

The largest risk to defined benefit plans is that minimum contributions must be made annually by the employer, with 25% of the minimum annual contribution paid into the plan quarterly. If, by the end of the tax year, additional amounts are necessary to maintain minimum funding, then any additional contribution necessary to close the funding gap can be made without penalty if done within 8½ months after the end of the tax year.

Moreover, the required contribution to a DB plan is based on an actuary's projection of the rate of investment growth and retirement objectives based on the taxpayer's age. So, although the annual contribution is stipulated by tax law, the taxpayer has some flexibility to adjust the contributions by adjusting the expected investment growth or retirement objectives within reasonable limits.